This is a chapter-by-chapter review of John Bogle’s Common Sense on Mutual Funds: Fully Updated 10th Anniversary Edition*. As the series progresses, I’ll create an index of each chapter.
Chapter 1 – On Long-Term Investing
Summary: To invest with success, you must be a long-term investor.
Bogle opens the chapter with a discussion of long-term growth rates for various asset classes (mainly stocks). Remember, that this version of the book is the old book with inserted or updated thoughts. In his discussion of long-term returns, Bogle added this, which I found interesting:
Despite the woes encountered by the stock market over the past decade, our economy continued to grow solidly, at a real (inflation-adjusted) rate of 1.7 percent, exactly half the 3.4 percent growth rate of the modern economic era. Despite the onset of recession in 2008, the gross national product (GNP) actually rose by [a] skinny 1.3 percent for the full year, although a decline (the first since 1991) of about 4 percent is projected for 2009.
But after this winder or our disciontentfrom mid-2008, through the winter of 2009we have enjoyed a spring and summer of recovery. for what it’s worth, the stock market provides far more value relative to our economy than was the case a decade ago. Then, the aggregate market value of U.S. stocks was 1.8 times the nation’s GNP, an all-time high; by mid-2009, with the value of the market at $10 trillion and hte GNP at $14 trillion, the ratio has tumbled to 0.7 times, 60 percent below the earlier peak, and roughly the same ratio as the historical average.
Not sure why he chose to use Gross National Product rather than Gross Domestic Product but I guess it doesn’t make much difference. The point to take from the quote is that the stock market isn’t as fully valued as it was ten years ago.
One thing that bugs me about chapter 1 is that Bogle relies heavily on Jeremy Siegel’s book, Stocks for the Long Run. The bulk of Siegel’s book is accurate but his data for index returns from 1802 to 1926 is unreliable because it was based on an index that was cherry-picked and consisted of very few stocks (more on this later).
Bogle then goes on to talk about the risk characteristics of both the stock and bond markets and shows how the wide swings (volatility) in market returns tend to dissapate the longer one stays in the market. Read this post to see what I mean. Bogle mentions that one way to fight the volatility of the stock market is to include bonds in your portfolio. This is pretty standard stuff.
The chapter then moves on to discuss costs. Basically, Bogle believes that when it comes to investing, you get what you don’t pay for. It’s very hard to beat the market so the only thing that keeps you performing as well as the market is costs. He breaks it down like so:
1. All investors own the entire stock market, so both active investors (as a group) and passive investorsholding all stocks at all timesmust match the gross return of the stock market.
2. The manage fees and transaction costs incurred by the active investors in the aggregate are substantially higher than those incurred by passive investors.
3. Therefore, because active and passive investments together must, by definition, earn equal gross returns, passive investors must earn the higher net return.
It’s important to note that Bogle is not saying that some active managers can’t outperform the market but that on the whole, they can’t because of expenses. Interesting thought.
He closes out the chapter with a list of six simple principals for long-term success (along with my thoughts):
1. Invest you must. For most people, there’s no other way to build wealth.
2. Time is your friend. Start as EARLY as you can and put the magic of compounding to work.
3. Impulse is your enemy. Don’t allow your emotions to take control.
4. Basic arithmetic works. Watch your investment expenses and keep them under control.
5. Stick to simplicity. Keep it simple by sticking with a simple asset allocation.
6. Stay the course. Through thick and thin, stay the course. Reread the other five principals when you feel yourself wavering.
Okay, there’s your review of Chapter 1 – On Long-Term Investing. Tomorrow we’ll look at Chapter 2 – On the Nature of Returns.